Author Topic: Roth vs Traditional 401k  (Read 1308 times)

Mostachio

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Roth vs Traditional 401k
« on: October 30, 2019, 07:05:17 PM »
Hello everyone! I've searched around a bit and couldnt find anything that quite addressed a question that's been on my mind, which is, with all things being equal would a traditional or roth employer-contributed 401k be more beneficial in the long run? For example's sake to keep it as simple as possible:

Unmarried and childless, no tax deductions or write-offs of any kind.
Constant income of $36,000/yr and no tax law changes ever.
Contributes 20% of income either into roth or traditional 401k with employer match.
Hypothetically has the exact same income of $36,000 (or at least same tax rate) both when they start contributing and when they retire (or withdraws $36,000 etc etc).

Is it a wash? Is it length of accumulation-phase dependent? I'm really just not sure if there's an easy answer I'm missing or if I'm overthinking it! I appreciate your help!
« Last Edit: October 30, 2019, 08:04:41 PM by Mostachio »

terran

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Re: Roth vs Traditional 401k
« Reply #1 on: October 30, 2019, 08:20:10 PM »
Yes, because of the commutative property of math, if all things are equal (namely total marginal tax rate) then Roth and traditional are equal.

To make things simple, let's say you have $10k to put in an IRA, you're in the 22% marginal tax bracket, there will be 10% growth next year and you're going to withdraw in a year. If you contribute to Roth you'll need to pay tax, so you can contribute $10,000 x (1-0.22) = $7,800 which grows to $7,800 x (1+0.1) = $8,580 when you withdraw tax free. If you contribute to traditional you can contribute $10,000 which grows to $10,000 x (1+0.1) = $11,000 when you pay tax to withdraw $11,000 x (1-0.22) = $8580. The same thing will happen over more years, different returns and different tax rates, it's just math.

Make sure you account for changes in state taxes like moving between a high tax and a low/no tax state in either direction, and the additional "tax" added by trying to qualify for ACA subsidies.

If you can afford to max out all tax advantaged space even if you contribute to Roth and have to pay the tax you could make the argument that (again, all other things being equal) you should contribute to Roth because then you have more of your money in tax advantaged instead of maxing traditional and putting the tax savings in a taxable account.

Will

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Re: Roth vs Traditional 401k
« Reply #2 on: October 30, 2019, 08:29:00 PM »
You could always do traditional and then convert to Roth after retirement.

Mostachio

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Re: Roth vs Traditional 401k
« Reply #3 on: October 30, 2019, 08:52:09 PM »
Yes, because of the commutative property of math, if all things are equal (namely total marginal tax rate) then Roth and traditional are equal.

To make things simple, let's say you have $10k to put in an IRA, you're in the 22% marginal tax bracket, there will be 10% growth next year and you're going to withdraw in a year. If you contribute to Roth you'll need to pay tax, so you can contribute $10,000 x (1-0.22) = $7,800 which grows to $7,800 x (1+0.1) = $8,580 when you withdraw tax free. If you contribute to traditional you can contribute $10,000 which grows to $10,000 x (1+0.1) = $11,000 when you pay tax to withdraw $11,000 x (1-0.22) = $8580. The same thing will happen over more years, different returns and different tax rates, it's just math.

Make sure you account for changes in state taxes like moving between a high tax and a low/no tax state in either direction, and the additional "tax" added by trying to qualify for ACA subsidies.

If you can afford to max out all tax advantaged space even if you contribute to Roth and have to pay the tax you could make the argument that (again, all other things being equal) you should contribute to Roth because then you have more of your money in tax advantaged instead of maxing traditional and putting the tax savings in a taxable account.

Thank you for the patient and helpful answer, especially the last part. Seems that the smartest thing I'll ever do is continue to ask dumb questions until I dont have any more! :)

MDM

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Re: Roth vs Traditional 401k
« Reply #4 on: October 31, 2019, 12:28:33 AM »
If you can afford to max out all tax advantaged space even if you contribute to Roth and have to pay the tax you could make the argument that (again, all other things being equal) you should contribute to Roth because then you have more of your money in tax advantaged instead of maxing traditional and putting the tax savings in a taxable account.
You could always do traditional and then convert to Roth after retirement.
And therein lies the question: how will one's future marginal rate compare with one's current marginal rate?

See Maxing out your retirement accounts if you want to quantify "how much lower?" could the retirement marginal rate be vs. the current one and Roth still be better.

Note that for $36K/yr gross, qualified dividends are likely to incur 0% tax so "not much lower if at all" is a good first guess for the OP's scenario.

seattlecyclone

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Re: Roth vs Traditional 401k
« Reply #5 on: October 31, 2019, 01:17:23 AM »
Of course it's important to examine the "all things are equal" part of this discussion.

On the one hand, if you save most of your retirement savings in a Roth account, those withdrawals won't count as income at all when you retire. The actual "income" you'll have from a tax perspective will need to come from other sources: traditional retirement account withdrawals, capital gains and dividends in a taxable account, pensions, rental real estate, work, etc. Will these things add up to anywhere close to what you're earning while working? Perhaps not.

On the other hand, if you plan to accept ACA subsidies toward your health insurance premiums during retirement prior to Medicare age, the phase-outs for these premiums may cause your total marginal rate to be pretty high even at relatively low income levels.

In the end it comes down to what your marginal rate is now compared to what you expect it to be during retirement. Unfortunately the latter number is not easy to compute with any certainty! It relies not only on how much you plan to withdraw during retirement, but also on what types of accounts you'll be withdrawing from, what you're planning to do for health insurance, whether Congress changes the tax laws between now and then (and in what direction), and a number of other things. Make the best guess you can and act accordingly.

ChpBstrd

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Re: Roth vs Traditional 401k
« Reply #6 on: November 04, 2019, 10:49:54 AM »
To make things simple, let's say you have $10k to put in an IRA, you're in the 22% marginal tax bracket, there will be 10% growth next year and you're going to withdraw in a year. If you contribute to Roth you'll need to pay tax, so you can contribute $10,000 x (1-0.22) = $7,800 which grows to $7,800 x (1+0.1) = $8,580 when you withdraw tax free. If you contribute to traditional you can contribute $10,000 which grows to $10,000 x (1+0.1) = $11,000 when you pay tax to withdraw $11,000 x (1-0.22) = $8580. The same thing will happen over more years, different returns and different tax rates, it's just math.

The only thing missing from this excellent illustration of the commutive property is the question of whether using the traditional IRA would pull one down into a lower tax bracket than one would be in during retirement. But of course thatís not all things being equal. :)

My rationale for favoring my traditional IRA is that Iím now in the 22% bracket but in retirement would be in the 12% bracket if the brackets donít change. Thus the traditional saves me 22% now and costs me 12% later, while the Roth is the inverse. That said, the max contribution to a traditional IRA maxes out at a much lower level than the Roth, so each year I calculate the maximum I can send to each account type. The $6k contribution limit for 2019 can be spread across the account types to the extent allowed by the limits. My rule is to send all Iím allowed to the traditional and the remainder of the $6k to Roth.

MDM

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Re: Roth vs Traditional 401k
« Reply #7 on: November 04, 2019, 12:49:31 PM »
That said, the max contribution to a traditional IRA maxes out at a much lower level than the Roth, so each year I calculate the maximum I can send to each account type. The $6k contribution limit for 2019 can be spread across the account types to the extent allowed by the limits. My rule is to send all Iím allowed to the traditional and the remainder of the $6k to Roth.
Is your income in the phase-out zone for IRA Deduction Limits?

Otherwise it's not clear how to interpret "send all Iím allowed to the traditional and the remainder of the $6k to Roth."

ChpBstrd

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Re: Roth vs Traditional 401k
« Reply #8 on: November 05, 2019, 07:03:18 AM »
That said, the max contribution to a traditional IRA maxes out at a much lower level than the Roth, so each year I calculate the maximum I can send to each account type. The $6k contribution limit for 2019 can be spread across the account types to the extent allowed by the limits. My rule is to send all Iím allowed to the traditional and the remainder of the $6k to Roth.
Is your income in the phase-out zone for IRA Deduction Limits?

Otherwise it's not clear how to interpret "send all Iím allowed to the traditional and the remainder of the $6k to Roth."

Correct. If it were not Iíd go 100% traditional.

Mostachio

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Re: Roth vs Traditional 401k
« Reply #9 on: November 07, 2019, 07:33:59 PM »
You could always do traditional and then convert to Roth after retirement.

Thank you for the suggestion, I will have to look into this more! I'm mostly researching general rule-of-thumb and layman perspectives for what we can consider the 'average' person in my local area, aka friends and loved ones! So conversions and the like that I would not think of are extremely appreciated! :)

And therein lies the question: how will one's future marginal rate compare with one's current marginal rate?

See Maxing out your retirement accounts if you want to quantify "how much lower?" could the retirement marginal rate be vs. the current one and Roth still be better.

Note that for $36K/yr gross, qualified dividends are likely to incur 0% tax so "not much lower if at all" is a good first guess for the OP's scenario.

As stated above, I'm trying to draw as close I can get to very general broad-strokes guidelines. This is the reasoning for using the $36k (or under $39k) for life number, because it seems to be possibly one of the blandest/simplest income levels in tax terms while also being close to the 'average'. To help me clarify, if one contributes nothing but Roth to a 401k for their lifetime (consistently $36k) are they liable for ANY income or capital gains tax if their withdrawals/dividends in retirement (60+) are also $36k? Also, if that person is a single person without kids, is it correct to assume they are not eligable for ANY tax-credits/deductions income-wise such as EITC? Just the standard deduction right?

@seattlecyclone It seems the above question is answered by you, but again, I ask to clarify. For the ACA portion it seems that I will need to research your link more, thank you for the resource! For this exercise, it's essentially a situation where someone makes $36,000 and their wage grows with inflation and hopefully with the adjustments in policy numbers pretty evenly.

@ChpBstrd I still need to evolve my guidelines a bit as my understanding of IRAs grows, so for now I'm sticking with 401ks and being optimistic that earnings in retirement will be even with or greater than earnings in accumulation. Kind of a 'my blue-collar friend plans to work til 60 and die at 80' plan tax-wise. Thank you for your insight in advance!

Edit: Suffice to say, I certainly appreciate you all helping me not reinvent the wheel but simply relearn the wheel. :)
« Last Edit: November 07, 2019, 08:27:06 PM by Mostachio »

MDM

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Re: Roth vs Traditional 401k
« Reply #10 on: November 07, 2019, 08:34:26 PM »
To help me clarify, if one contributes nothing but Roth to a 401k for their lifetime (consistently $36k) are they liable for ANY income or capital gains tax if their withdrawals/dividends in retirement (60+) are also $36k?
No.

Quote
Also, if that person is a single person without kids, is it correct to assume they are not eligable for ANY tax-credits/deductions income-wise such as EITC? Just the standard deduction right?
Correct, one is not if all contributions are Roth.  The first tier of the saver's credit is in reach, however, should one use traditional contributions.


To compare apples vs. apples, be careful about how you define "Contributes 20% of income either into roth or traditional 401k...."  A $7200 traditional contribution would save $1,064 ($864 from the 12% bracket plus $200 saver's credit) and thus be the same as a $6,136 Roth contribution in terms of spendable income.  You would also have to define how the employer match works.